This week’s U.S. inflation report could have serious implications for stocks

At the very least, a smaller than expected rise in inflation could encourage Fed Chair Jerome Powell to more forcefully prime the market for a rate cut at the Fed’s September meeting, but some believe that a sufficiently weak number could even open the door to a rate cut in a few weeks, something that futures-market traders have dismissed as extremely unlikely, according to CME Group data.

Meanwhile, a hotter-than-expected reading, seen as unlikely by most economists, could stop the stock-market rally in its tracks.

Both Fundstrat’s Tom Lee and Renaissance Macro’s Neil Dutta warned that Wall Street might be underestimating the possibility of a cut at the Fed’s July meeting in commentary shared with MarketWatch on Friday. Investors would do well to take their views seriously — after all, both have nailed out-of-consensus calls on markets and the economy recently.

“If this is another soft reading, there is a possibility of a Fed cut at the July [Federal Open Market Committee] meeting,” Lee said in written commentary.

Dutta added during an interview with MarketWatch that he believes chances of a cut in July have been ”underpriced.”

For the past several months, the RenMac economist has argued that the Fed needs to “get on with it” and cut rates as soon as possible to avert a more painful economic downturn.

If Thursday’s CPI data do undershoot, stocks would likely rally alongside bonds as Treasury yields continue their recent slide.

CPI data days have typically elicited a notable reaction in stocks since the Fed started raising interest rates in early 2022, Dow Jones Market Data show. To be sure, the magnitude of these swings has waned as inflation has slowed.

Still, stocks have seen an average move of 0.9% on CPI days since the beginning of the year — nearly twice the S&P 500’s daily average move of 0.5% through Friday.

Perhaps more importantly, any indication that the Fed might be close to cutting rates could help to boost corners of the market that have lagged the S&P 500. Small caps and more cyclical and interest-rate sensitive stocks like those belonging to the real-estate sector could zoom higher, Wall Street professionals said.

Real estate has been the worst performer among the S&P 500’s 11 sectors over the past year, while the small-cap Russell 2000 index
RUT
has moved marginally lower since the start of 2024, according to FactSet data.

“When the Fed does cut rates, that could be the catalyst for the market to broaden out,” said Joseph Gaffoglio, president of Mutual of America Capital Management, during an interview with MarketWatch.

Gaffoglio prefaced this by saying he doesn’t expect the Fed will move to lower borrowing costs any time soon. He believes at most one cut later this year in either November or December is more likely.

Economists polled by The Wall Street Journal expected headline inflation to slow to 3.1% year-over-year in June, from 3.3% in May, while core inflation, a more closely watched measure that strips out volatile food and energy costs, is expected to remain steady at 3.4%.

If anything, monthly jobs data from the Labor Department released Friday helped to strengthen Dutta’s argument that the Fed should act sooner rather than later. The report offered yet more evidence that the labor market has started to cool.

The unemployment rate climbed to its highest level since late 2021 in June, while the pace of wage growth — seen as a reliable harbinger of inflation — slowed.

Although more than 200,000 new jobs were created, numbers from the prior two months were revised lower by a combined 111,000, weighing on the three-month average.

This was consistent with other recently released data, which together have portrayed an economy that has started to buckle under the weight of the highest interest rates in more than 20 years.

Official data put the GDP growth rate during the first quarter at 1.4%, while a real-time indicator published by the Atlanta Fed has penciled in 1.5% pace for the second quarter. By comparison, real GDP expanded at a rate of 3.4% during the fourth quarter.

“GDP growth is clearly slowing,” Dutta said. “The risk now is that the Fed has overstayed their welcome with higher for longer rates.”

Others offered a different interpretation of the latest labor-market report. Some highlighted the fact that the uptick in the unemployment rate was driven by more workers entering the labor force, not mass layoffs.

Powell acknowledged during a recent central-bank conference in Sintra, Portugal that an inflationary scare from earlier this year had passed, and that the U.S. economy appeared to be back on the path of disinflation.

However, the Fed chair added that inflation likely wouldn’t return to the Fed’s 2% target until late 2025 or in 2026, and that the risks surrounding both consumer prices and the labor market had moved back into balance — meaning that the Fed must consider both equally.

Minutes from the Fed’s most recent meeting in May suggested that officials remain divided about how much more evidence of slowing inflation is needed, although some said they were watching for signs that the economic slowdown could intensify. Whether a soft report in June might do the trick remains to be seen.

Stocks finished higher on Friday as futures traders bet that the latest data would make a Fed rate cut in September more likely. The S&P 500
SPX
gained 30.17 points, or 0.5%, to finish at 5,567.19, the index’s 34th record closing high of 2024. The Nasdaq Composite
COMP
rose by 164.46 points, or 0.9%, to 18,352.76, its 24th record of 2024.

The Dow Jones Industrial Average
DJIA,
meanwhile, gained 67.87 points, or 0.2%, at 39,375.87.